How does corruption affect Foreign Direct Investment in developing economies?

With the liberalization of many developing economies, Foreign Direct Investment (FDI) has become a crucial medium through which developing economies become connected with each other. However, the amount of FDI for developing economies is not evenly distributed. Does the level of corruption in certain countries affect their attractiveness for FDI? An analysis by SBE visiting scholar Dr. Devrim Dumludag.

A firm usually decides to invest abroad to better serve the local market or to get lower-cost inputs, or both. In other words, FDI can be divided into horizontal, or market-seeking FDI, and vertical, or efficiency seeking, FDI.

What if, a country with a large domestic market or a relatively cheap skilled labor force cannot receive adequate FDI in relation to its potential? Or, to look at the question more generally, what factors matter for FDI?

I believe that good institutions such as political stability, rule of law and low level of corruption contribute not only to attract FDI inflow but also have a positive influence on economic development through the stimulation of investment in general, as it faces less uncertainty and higher expected rates of return.

Globalization and FDI

One of the most notable features of economic globalization has been the increased importance of foreign direct investment around the world. The dramatic rise in FDI flows in recent years stands out as one of the most decisive factors in the globalization of the economic activity and FDI is viewed as a measure of the extent to which a country or a region is integrating into the world economy.

In developing economies, governments believe that FDI will help economic development and therefore try to attract FDI through policies and investment incentives designed to increase investors’ interest.

A rapid increase in FDI inflow has been observed in developing countries in the past three years. Based on UNCTAD estimates, the annual net flow of FDI to developing countries jumped from USD 15 billion in 1980 to USD 150 billion in 1997 and USD 500 billion in 2010.

Corruption and FDI

The uneven distribution of FDI in developing economies may limit the potential for growth; therefore it is important to try to understand the reasons for this discrepancy. One of the explanations for the low level of FDI flow in some countries is the high level of corruption that exists in them.

Corruption implies secrecy and illegality, the misuse of public power for private benefit and can take various forms across different economic activities.

Corruption within the political system is a threat to foreign investment. By enabling people to assume positions of power through patronage rather than ability, it introduces inherent instability into the political process thereby distorting the economic and financial environment.

Corruption can affect every sector and level of the government, from the top executive, legislative and judicial branches down to regional and local officials, thereby reducing its efficiency. It presents therefore a potential threat to all sectors and institutions within a country.

Corruption is a complex phenomenon to measure. Due to the lack of reliable data on corruption, theories are difficult to test. However, the number of studies dealing with the issue by using various comparative methods has been increasing.

In order to measure the level of corruption in a country, various international organizations such as the Political Risk Service (PRS), Transparency International (TI), the World Business Environment Survey (WBES) of the World Bank, the Global Competitiveness Report, and the Freedom House have been carrying out surveys in a number of Multinational Corporations (MNCs) operating in host economies. Using these data scholars are now able to examine the relationship between corruption, economic growth, and FDI.

Corruption perceptions index 2011 – The perceived levels of public-sector corruption in 183 countries/territories around the world(Source: Transparency International 2011)

The measure for perception is a combination of various studies that evaluate how business people and the public in general view the level of corruption within a country. The countries measured are rated on a scale from 1-10, where 1 is very corrupt and 10 is the least corrupt.

Corruption can affect FDI directly by tarnishing the perception of a country’s stability and quality of an investment potential. Foreign investors perceive corruption as an impediment to investing in the host country.

Debates on the effect of corruption

Corruption is seen as an extra cost for operations. However, the effect of corruption on economic growth, and more specifically on FDI, has been subject to debate. Some argue that, bribes act as speed money and help avoid bureaucratic inefficiencies. Corruption is also claimed to have a beneficial face which is known as “greasing the wheel”.

In other words, while corruption has harmful long-term effects, it can bring economic growth in the short term. Also, in the case of developing countries, where governments are inefficient, corruption may be the only way to encourage investment by offering alternative ways to conduct business.

However, over time, the empirical evidence of the negative effects of corruption has steadily increased. For instance, the Business International (BI) indices have been used to argue that corruption does in fact hurt growth and investment.

Conclusion

Corruption can affect FDI directly by ruining the perception of stability and quality of an investment potential in host countries. Investors may prefer not to invest because of extra costs. Foreign investors generally avoid engaging in corruption because it is considered wrong and it can create operational inefficiencies.

One should be careful, however, about generalizing the causes and effects of corruption to all countries. Corruption can become very much a part of a country‘s life and the causes and effects can be seen in its history and society.

Since there are different types of corruption, there are also different solutions.

Efforts towards raising the quality of institutions (in this case, in order to diminish corruption) may help developing economies to receive more FDI, and therefore help them enjoy higher GDP per capita.

Dr. Devrim Dumludag received a PhD in economic history at Bogazici University, Istanbul. He was a postdoc at department of economics at Groningen University in 2008 and he was a visiting scholar at the Erasmus University of Rotterdam in 2009. Now he is a visiting scholar at department of economics at Maastricht University and his area of interests are institutions and economic development, behavioral economics and happiness economics. His current project is about relative income effect on subjective well-being.